Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

SUMMARY

• Interest rate floors are a form of interest rate derivatives. These are over-the-counter derivatives that protect the holder from declines in short-term interest rates by making a payment to the buyer when an underlying reference rate falls below a specified rate, known as the floor rate or the strike rate. The holder of a floor instrument pays a premium for protection against decline in interest rates. For each period, the payment is determined by comparing the current level of the reference rate with the agreed floor rate. If the reference rate is below the floor rate, the payment is calculated with reference to the difference between the two rates, the length of the period, and the notional amount of the contract.
• Again interest rate floors are of two types—the first type being “to pay.” This means that for receiving an agreed premium, the buyer of this type of instrument agrees to compensate the seller of the instrument on the pay date any interest falling below the floor rate, if the benchmark interest rate is below the floor rate on the reset date. The premium is computed like any other option premium based on some mathematical model that takes into account several factors including the strike rate (floor rate), the present benchmark interest rate, the historical volatility of interest rates, the time period of the contract, amongst other factors.
• The second type of interest rate floors is known as “to receive.” This means that for paying an agreed premium, the seller ...